US National Debt & Budget Deficit Explained | Economics 101

The US government finances deficits by issuing Treasury securities: Bills (up to 1 year), Notes (2-10 years), and Bonds (up to 30 years). These are purchased by banks, pension funds, foreign governments, and the Federal Reserve. The Fed cannot directly buy Treasuries from the Treasury but purchases them on the secondary market to control interest rates, maintain bank reserves, and absorb liquidity fluctuations. This intervention affects bond prices and yields, making government borrowing easier.

The Federal Reserve can now buy treasuries in the open market, which is almost the same as buying them directly from the treasury. This enables the government to run up all these debts. The relationship between the Federal Reserve and the Treasury is cozy, with Wall Street banks making money on the commissions for all the treasuries that go from the U.S. Treasury to Wall Street and then to the Federal Reserve. This relationship encourages the Treasury to go deeper into debt knowing the Fed will be able to buy the bonds.

US Treasury Bonds are debt instruments issued by the US Government. The Federal Reserve controls the US money supply through two methods: digitally adding/subtracting money from major banks and by issuing, buying, and selling US Treasury Bonds. When financial entities buy Treasury Bonds, they give dollars to the Federal Reserve, which removes money from circulation. When entities sell bonds back to the Fed, money is added back to circulation.

The US Treasury and Federal Reserve have a symbiotic relationship in money creation. The Treasury spends according to approved budgets and then raises revenue through taxes. When the Treasury cannot raise enough revenue, it issues debt. The Federal Reserve purchases this debt, creating new dollars in the process. When bonds mature, the Treasury must repay the principal plus interest, requiring new debt issuance. This cycle affects bank reserves and liquidity in the financial system.

The Federal Reserve creates money by purchasing government debt (Treasury securities). This means the dollar is backed by government debt, not by any commodity. The Federal Reserve's role is to manage the supply of this debt-based currency, which has led to repeated currency crises.

This section presents economic theory explaining why government borrowing may not stimulate private investment. The crowding out effect occurs when government borrows from the marketplace, making funds unavailable for private sector investment in factories, pipelines, and technology. Alternatively, money printing causes inflation by increasing supply faster than production. Research shows high-debt countries experience households and businesses holding back on their own investments. Israel's 1990s experience demonstrates this: running deficits at 6% interest starved the economy of productive investment until fiscal discipline restored private sector dynamism, triggering a venture capital boom that produced more NASDAQ-listed companies than all of Europe.

The Crowding Out Theory is an economic concept that suggests when governments increase public debt, they compete with private sector borrowing for limited funds. This competition drives up interest rates, making it more expensive for businesses to borrow money for investment. The theory argues that this reduced access to capital leads to decreased private investment and ultimately slower economic growth. The theory is based on the premise that money is a finite resource, and government borrowing reduces the funds available for private sector investment.

The crowding out theory, derived from the loanable funds model, argues that when governments borrow large amounts, they reduce the funds available for private sector investment. This reduction in private investment allegedly leads to lower productivity growth, which in turn causes debt levels to spiral out of control. The theory suggests that to avoid this outcome, governments must cut spending to allow private sector investment to flourish.

The crowding out effect occurs when increased government borrowing raises interest rates, thereby reducing private business investment; this phenomenon can be graphically analyzed through two approaches: (1) shifting the demand curve for loanable funds to the right as the government competes for funds, or (2) shifting the supply curve to the left as deficits siphon away household savings from business investment, both resulting in higher interest rates and reduced private investment.

The crowding-out effect occurs when expansionary fiscal policy (increased government spending) raises interest rates, thereby reducing private investment and diminishing the overall effectiveness of the fiscal stimulus on economic growth; this happens because increased aggregate demand raises money demand, leading to higher interest rates that inversely affect private investment decisions.

Modern Monetary Theory (MMT) explains that governments that print their own currency, like the United States, fundamentally differ from households or cities because they can spend more than they collect in taxes without running out of money. The government creates money by spending it into the economy, and citizens earn this money to pay their taxes. Deficits represent the net flow of money into the economy rather than a government financial problem. The primary constraint for currency-sovereign governments is not running out of money but printing too much, which can cause inflation. This contrasts with countries like Greece that use foreign currencies and must borrow money from capital markets, facing interest rate constraints set by external lenders.

According to MMT, the only real economic limit to government spending is inflation, not debt or deficits. JFK reportedly asked James Tobin if there were any economic limits to deficits, and Tobin replied that the only limit is inflation. Under the gold standard, printing money required acquiring more gold, but fiat currencies are backed by the goods and services they can purchase. Printing more money requires growing the real economy's output to prevent inflation. The key question for governments should be 'how shall we resource it?' rather than 'how should we pay for it?' Critics argue MMT is essentially Keynesian economics with new terminology, and that independent central banks with authority to discipline governments help maintain low inflation expectations through rational expectations signaling.

Modern Monetary Theory (MMT) is an economic framework that explains how sovereign governments with their own fiat currency systems operate, arguing that such governments can create money without limit and that deficits are not inherently problematic; however, this theory faces significant theoretical challenges including problematic definitions of money, the exclusion of commodity money, and the difficulty of establishing purchasing power without historical commodity backing, while its policy implications like the job guarantee program may lead to either increased government control or inflation.

Modern Monetary Theory (MMT) explains that sovereign governments issuing their own currency cannot run out of money. They can always make payments as they come due by spending first and collecting taxes afterward. The real constraint is resource availability, not finance. When approaching full employment, continued spending causes inflation, which serves as the natural limit. This differs from currency-pegged or foreign-debt-dependent economies like Venezuela.

MMT is an academic economic theory that provides an accurate description of how fiat currencies actually work. It explains that countries with their own sovereign currency, like the US or UK, are not constrained by tax revenues when spending, because they can always create more money. The theory challenges traditional thinking about government deficits and spending limits.

This segment provides a comprehensive comparison between Greece's sovereign debt crisis and Japan's fiscal situation across three structural dimensions: (1) Debt ownership - Greece's debt was 80% foreign-held, making it vulnerable to investor sentiment; Japan's debt is 80% domestically held, providing stability; (2) Current account balance - Greece had a deficit, Japan has a surplus; (3) Currency denomination - Greece issued euros (foreign currency), Japan issues yen (own currency). The segment also notes emerging trends where foreign ownership of Japanese debt is increasing, potentially changing this structural advantage.

Countries with foreign currency-denominated debt face significantly higher risks of fiscal collapse. When Argentina's debt-to-GDP ratio was 50%, it appeared manageable, but after the peso collapsed against the dollar, the effective debt burden jumped to 150%. Greece experienced fiscal collapse despite having a lower debt-to-GDP ratio than Japan because Greece's debt was denominated in euros (a foreign currency for Greece), while Japan's debt is denominated in yen (its own currency). This fundamental difference in currency denomination explains why Greece faced collapse while Japan did not.

National debt sustainability depends on currency denomination and ownership structure. Countries with debt denominated in their own currency and held domestically face different risks than those with foreign-denominated debt. The US dollar's status as a global reserve currency provides stability, as all central banks inject money, causing currency devaluation that maintains demand for dollar-denominated assets. Different economic crises cannot be directly compared due to fundamental structural differences. The Great Depression was primarily an economic crisis driven by industrial overcapacity, while modern crises are often health-related that subsequently impact the economy. Modern economies are more diversified, with no single sector exceeding 10% of GDP, unlike 1929 when agriculture and industry dominated.

Unlike Greece, the US has unique advantages preventing traditional debt crisis: (1) Currency sovereignty—the Fed can print dollars, meaning the US can never run out of money to pay debts (though this risks inflation); (2) Global reserve currency status—over half of global foreign reserves are in dollars, creating continuous demand for Treasuries; (3) Economic diversity and size provide resilience. The real threat is not sudden default but gradual economic erosion from rising interest costs and potential loss of confidence.

Greece and Japan are not in similar situations. Greece borrowed from foreign banks in euros (a currency it couldn't print), while Japan's debt is held domestically in yen (which Japan can print). Greece was forced into the eurozone by political decisions, while Japan has full monetary sovereignty over its debt.